What is a Roth 401K?

Does your employer sponsor a Roth account as one of the retirement options? If yes, you will be glad to know that employees saving funds for their retirement are increasingly choosing the Roth option over the traditional 401k alternative. Benefits consultant, Aon Hewitt, included it in the Universe Benchmarks report.

When employees have the 401k Roth option available to them, 12% of them contribute to a Roth 401k. This is an increase from 2012, where the percentage increase was 9.8%, and in 2011, where the number was 8.4%. This report was an analysis on the behavior of about 3.5 million employees who opted for the Roth 401k plan in over 140 large organizations. It also sheds some light on employees’ decision-making process and recommends that more employers should sponsor the Roth alternative.

Definition of Roth 401k

A Roth 401k is a savings account, which employers sponsor. The funding comes from post-tax money up to limit of the plan. It is an ideal investment saving account for employees who want to avoid the likelihood of ending up in a higher tax bracket compared to their current tax bracket. It is more attractive than the conventional 401k plan, which is financed with pretax funds and, therefore, incurs tax levies on all future withdrawals.

Contributions from employees come via post-tax dollars and there is no income limitation for participating in this plan. Roth 401k accounts have a contribution limit, which depends on the participant’s age.

For instance, for employees with age 50 or below, the contribution limit was $18,000 per year in 2016. People who are above the age of 50 can contribute up to $24,000 annually; with room for an additional $6,000 of eligible contributions known as catch-up contributions.

In case you withdraw any earnings or contributions, they are not subject to tax. This is only if the withdrawal qualifies as a distribution. Distributions are mandatory for people who are at least 70.5 years old. They may be exempt if they are still in employment and do not own a 5% stake in the business.

Qualified Distributions

Earnings and contributions in a 401k account are eligible for withdrawal without any income tax consequences if you meet specific criteria. In Roth 401k, the savings account must have remained open for a minimum of 5 years. Moreover, the amount must have been withdrawn in the event of a disability, after or on the expiry of the account holder, or when the account owner reaches the age of 59.5 years.

Strategy for a Roth 401k Account

Individuals who tend to benefit the most from a Roth 401k are those who currently belong to low-tax brackets and in the future expect to move into higher-tax brackets. The reason is that contributions are taxed immediately at a comparatively lower rate of tax while distributions have no tax implications when the employee transitions into a higher tax bracket.

This is the main reason why a Roth 401k is not the best option for people who expect to move into lower tax brackets (like individuals approaching the age of retirement and expect a dip in income).

Who Makes the Most Contributions to a Roth 401k?

Young people generally favor Roth 401k accounts. Over 17% of young employees (in early 20s) made Roth 401k contributions, which is higher in comparison to 9% of older employees (in their 50s). The numbers lend credibility to the assertion that young employees are benefiting more from Roth 401k option, provided they are making fewer dollars and, therefore, have a lower tax rate. Here is the breakup by age.

Age Percentage of employees using Roth

20-29 17.2%

30-39 13.1%

40-49 10.2%

50-59 8.9%

60+ 5.7%

Roth 401(k) accounts are more popular among men. 11.9% of male employees make Roth 401k contributions in comparison to 9.8% of women. In terms of salary, employees earning $60,000 to $79,000 have the greatest Roth contribution, i.e. 13.6%.

With respect to tenure, Roth usage declines as tenure increases. About 15% of employees who have been in employment for 2 to 3 years made contributions to Roth 401k which is higher than 9.1% of employees who have a tenure of 20 to 30 years, and only 7.6% for employees who have been in employment for over 30 years.

Benefits of a Roth 401k Account

When you use a Roth account, you utilize post-tax income. The deduction has been made from your paycheck for contributing to the Roth account. However, once the deduction has been made, your funds grow tax-free and are not subjected to taxes when you make withdrawals in your 60s.

If you currently belong to a low-income bracket — for example, in case you are young and have just started a job and expect you will end up in a high-tax bracket by the time you retire, a Roth 401k makes sense. Eventually, you will pay up-front taxes at a time when your actual tax expense will be low.

Another major benefit of a Roth account, apart from lower taxes, is it allows you to tap a major chunk of your Roth funds during retirement to pay for items, like medical emergencies. You can avoid tax bills, as you would in case you have a traditional 401k.

Roth 401k investors are usually implicitly betting that tax rates will stay consistent in the future. The Roth alternative mostly attracts young employees since it allows them to lock in lower tax rates at the outset. But they will suffer financially if the average tax rate actually decreased in the next 25 years; let’s say in favor of a value-added tax.

Conclusion

The decision to contribute to a conventional 401k or a Roth 401k account is in a sense akin to a coin toss. There are myriad variables to consider, but fortunately, there are a few guidelines. If you contribute to a traditional 401k account, your contributions are pre-tax. This means you will benefit from a tax break immediately. However, you will need to dole out taxes when you withdraw funds. On the other hand, in case of a Roth 401k account, you will contribute with post-tax cash. The funds, including earnings that you contribute are free of any tax on retirement.

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